A second economy—the Creative Economy—is continuously innovating and adding value to the economy, through continuous innovation.

A third economy—the Financial Sector—has strayed from its proper social function of funding the real economy which provides real goods and services and devotes significant effort to making money out of money. It engages in large-scale zero-sum games (or even negative-sum games) in which one group of people make money at the expense of another group of people. It gives little thought to tomorrow: its concern is how much money it can make today.

In its zero- or negative-sum games, the Financial Sector acts like a vampire and extracts value from both the Traditional Economy and the Creative Economy. By sacrificing the future for the present, it helps set the country on a path to high volatility, stagnant wages for average citizens and secular economic decline.

Most people are vaguely aware of the vampire-like activities of the Financial Sector in causing the global financial meltdown of 2008 and engaging in widespread illegality, with fines and legal costs amounting to more than $100 billion. But they imagine the activities to be perpetrated by the pin-striped suits of Wall Street. The news this week is that the suits of Wall Street have been joined by pension fund managers who represent ordinary citizens like the school-teachers of California.

Whereas some pension funds like Calpers have wisely announced that they will no longer have anything to do with hedge funds, CalSTRS, the pension fund of California school teachers, is now leading the charge in stripping the value from the real economy.

The Creative Economy in this story is represented by a company in Canton Ohio called The Timken Company, which has been making steel and bearings for almost a hundred years. It’s the kind of firm where “making things still matters.” Unlike other companies in the region, like Goodyear Tire & Rubber or the Hoover Company, Timken has not tried to cut costs by moving production to other countries where labor is cheaper. Instead Timken has made huge capital investments in Canton Ohio. For instance, “the company spent $225 million to expand its steel mill allowing Timken to innovate, dominate the market for high-margin, specialized steel, and stay ahead of rivals in South Korea, Japan and Germany… While the steel industry may not seem high-tech, research and innovation is critical — about a third of the products TimkenSteel sells now were developed only in the last five years.” Timken has also put a sizable amount of its profits into Canton in the form of good wages and donations to schools and arts.

The Financial Sector in this story is represented by two actors. One actor, Relational Investors, is what you’d expect. It’s a firm that claims to “create long-term growth in publicly traded, underperforming companies that it believes are undervalued in the marketplace.” In fact, its modus operandi involves acquiring stakes in companies, pressuring them to make changes to “unlock value”, insisting that firms load themselves up with debt, buy back their own shares, return assets to shareholders and drive their share prices higher. Then it cashes in its profits and moves on to the next victim, with no thought for financially fragile state in which it leaves the companies it has attacked.

Relational’s raid on Timken was very successful. “It was run in a campaign style… Relational had done it before and they had the infrastructure to do it… All told, Relational acquired its stake at about $40 a share and sold at $70, reaping a 75 percent gain — $188 million — in just over two years.”

In the process, Relational created no jobs and made no products or services for any real people. It simply extracted money that had been created over years by the hard work of Timken’s management and workers. Nor does Relational have to worry about what will happen to Timken, now that it has been broken up into two separate companies, or about what may happen to jobs in Canton. “By the fall, the San Diego activist firm had unloaded its entire position in both Timken and TimkenSteel.”

The other, more surprising, actor in this case is the California State Teachers’ Retirement System, known as CalSTRS, representing some 236,000 teachers and other retirees in California, “One of the nation’s largest public pension funds, with $187 billion in assets, CalSTRS owned only $16 million worth of Timken stock at the start of the fight, compared with $250 million for Relational, but it also has more than a billion dollars under management with Relational..”

How Relational used CalSTRS

CalSTRS was the perfect cover for Relational, because “Timken was a risky target for Relational’s executives: They could be painted as Gordon Gekko types trying to make a fast buck by attacking a well-regarded, family-run company that had outperformed the stock market.”

Having a pension fund like CalSTRS as a partner enabled Relational to make it appear that in breaking up Timken it was virtually performing a public service, helping the embattled school teachers of California overcome the plutocrats of Canton Ohio and “unlocking hidden value” in Timken.

Thus CalSTRS joined in attacking the $9 million pay package of Timken’s chairman as “grossly out-of-line with other executive chairmen in Timken’s peer group.” With Relational’s well-rehearsed campaign tactics, it portrayed the Timken management as a “Timken family-dominated board… that apparently only serves their interests.” An investment officer from CalSTRS “joined the roadshow organized for investors by Relational, flying to New York to meet fellow pension fund managers and press for a breakup.”

After its strident complaints at the Timken chairman’s pay package of $9 million, which was the result of decades of creating jobs and adding value to the community in Canton, Ohio, CalSTRS has yet to show any moral indignation at Relational’s compensation of $188 million, for two year’s work that created no jobs and made Timken—and Canton, Ohio—more financially fragile.

CalSTRS is unrepentant about the risks to Canton. Their investment officer, Mr. Larrieu, said. “It’s a tough environment. But my job is to make the highest return to pay for the teachers’ retirement.” If there is any evil here, it is the banal evil of a bureaucrat just doing what he imagines to be his job.

Why split Timken?

The heart of the CalSTRS/Relational argument for breaking up Timken was that the firm would be more valuable as assets to be sold, rather than as a going concern. Investors, it was said, should be able to decide for themselves whether to invest in “the faster-growing but more volatile steel business or the more mature but highly profitable bearing business.” The fact that a dismantled Timken would be less financially resilient in the future was irrelevant. The only thing that mattered was what price it might fetch in the stock market today.

CalSTRS and Relational maintained that “if the money couldn’t be invested in the business now or in the foreseeable future, it should be returned to shareholders, who are, after all, the owners of the company.” The fact that neither CalSTRS nor Relational had done anything to create the value in Timken in the first place was irrelevant, as was the fact that breaking it up might undermine its capacity to create value in the future.

“Buybacks and increased leverage on the balance sheet can work fine in some sectors,” the article points out, citing Bill George, former CEO of Medtronic “But they can be lethal in industries that require long-term thinking and big investments to stay competitive, like heavy industry and health care.”

The case for breaking up Timken also ignored “the case for keeping bearings and steel under one roof. Bearings require specialized steel that can, for example, withstand enormous pressure deep underwater in an offshore oil well. The metallurgical expertise the steel unit acquired in creating these advanced materials, they said, translated into products for other customers like medical device makers and drillers.”

“There were other structural reasons for the two companies to stay together. Because the steel business can be very profitable but is much more volatile, the bearings division served as ballast for the combined company. Excess cash from the bearing side smoothed out those peaks and valleys and helped pay for big investments like the huge caster.”

“The steel business is also notoriously cyclical,” which is why Timken declined to undertake large scale borrowing and preferred “to have a cash cushion to sustain product development and new investments during the inevitable lean years.”

A victory for Wall Street

But the opportunistic activists prevailed: 53 percent of shareholders voted for the split into two companies and Timken was broken up into two companies: Timken and TimkenSteel

Already Wall Street is salivating at the prospect of buyouts. Thus “analysts at Jefferies were calling Timken ‘a reasonable leveraged buyout candidate’ and rating potential buyers… Analysts at Gabelli & Company reached a similar conclusion. ‘We believe an acquisition has better than even odds one to two years out’… That TimkenSteel had little debt and an overfunded pension plan at the time of the spinoff, Gabelli added, makes its balance sheet ‘ripe for a sale.’”

“In the looking-glass world of Wall Street, the Timken family’s conservative approach to running the company has made it an appealing target for giant rivals or private equity firms — even though those buyers might ultimately undermine the very strategy that made it successful in the first place.”

Timken is already a relatively small player in global terms. Splitting it up aggravates that issue.

“TimkenSteel’s market capitalization is less than a tenth of that of Nucor, which is now the country’s biggest steel producer. If TimkenSteel is swallowed by a larger competitor, like Nucor, ArcelorMittal or United States Steel, the mills in Canton won’t grind to a halt anytime soon. But an owner from another state — or country — is unlikely to be so committed to keeping jobs in Canton, let alone backing a downtown arts district or local high school.”

“Buried in a November Timken investor presentation is a chart bound to please Wall Street. Titled ‘Yesterday and Tomorrow,’it sketches how capital was allocated before the split, and how it will be used now. Pension fund contributions drop from nearly a third of cash flow to near zero, while capital spending is roughly halved. And instead of using 12 percent of cash flow to buy back stock, share repurchases will consume nearly half of cash flow over the next 18 months. In other words, less cash is being invested in the business or earmarked for benefits to employees, and more money is going to investors. While TimkenSteel’s board has authorized a three million share buyback by the end of 2016, Timken has plans to repurchase 10 million shares by the end of next year.”

The larger story

Timken is one case. But it is not alone. Extracting value for shareholders is creating secular stagnation in the US economy. As research by Professor William Lazonick shows, between 2004 and 2013, some $3.4 trillion have been devoted to share buybacks rather than investments. Although the stock market is booming, fueled by cheap money from the Fed, the real performance of the economy is one of continuing decline.

“In the microcosm of Timken, you can see the larger forces playing out in manufacturing in America.,” said Suzanne Berger, a professor of political science at M.I.T., and author of the 2013 book, Making In America, ““We’ve got a financial system in the U.S. where California teachers have to protect their pension funds by hurting manufacturing in Ohio.”

Yet that result is not inevitable. CalSTRS is not obliged to provide moral cover to Relational’s predatory form of capitalism. Calpers has announced that it is getting out of such predatory activities. Why not CalSTRS?

Did Timken give in too easily?

On one important issue, the NYT article is in error. It says: “As in all publicly traded companies, TimkenSteel’s board and top executives have a fiduciary duty to shareholders to maximize both profits and investor returns.”

Except in narrow circumstances, that is simply not true, as Professor Lynn Stout has shown in her book, The Shareholder Value Myth. The board and top executives have a fiduciary duty to use sound business judgment. In this case, says Professor William Lazonick argues, sound business judgment would mean maintaining the integration of the manufacture of specialty steel and ball bearings, also that the shareholder vote of 53 percent for the split was non-binding on management. So why didn't Timken management put up more of a fight?

A lesson from Europe

Nor is the whole approach of vampire capitalism in the Financial Sector inevitable. For example, in Germany, Austria and Switzerland., economic and business historians have been increasingly giving more and more credit for Germany's economic growth due to what is known as the Mittelstand--small and medium-sized enterprises in German-speaking countries.

Mittelstand companies are efficient and highly focused on learning to do the one thing really well, while diversifying internationally to achieve economies of scale.” They also have access to highly skilled workers as a Germany's apprenticeship system. Labor relations are also more collaborative in spirit. They focus on innovative and high-value manufactured products. They are often privately owned and based in small, rural communities. They combine a cautious and long-term-oriented approach to business with management practices, such as lean manufacturing and total quality management.

Thus the vampire capitalism represented in the Timken story, and now prevalent in the US, is a choice, not an inevitability. Isn’t it time that the America made the right choice?